Fed Needs To Speed Up Taper, Smooth Out Distortions

Over the past six years, central banks around the world have engaged in what can only be described as the greatest monetary experiment in the last century. Now, the world is awash in liquidity, and as a consequence, financial markets are distorted. Interest rates are artificially low, squeezing retirees and pressing investors to stretch for return with less regard to risk. Banks limit lending and businesses avoid investing.

Now, the Fed’s task is to extricate itself from this grand experiment beginning with the taper and to do so with minimal disruption. This may seem an easy assignment given the buoyant equity market, the occurrence of high-profile, multi-billion deals such as the purchase of WhatsApp by Facebook, and the notion that the taper has somehow already been priced into the market.

However, the idea that a reversal from what has been the greatest synchronized monetary ease in recent history could occur without a hitch is foolish. This is a herculean task in which the Fed will need to take a hard look at its mandate and increase coordination with other central banks around the world, particularly in emerging markets.

The hope that potential damage from the taper will be limited since the market has already “priced in” the event is naïve. This hope is simply not supported by history. Lessons from the recent past vividly illustrate that even if market participants know an event is going to happen, markets still get roiled once the event actually unfolds. Consider the following examples:

• NASDAQ – In late 1999 and early 2000, many market participants were expecting a correction in tech stocks before the collapse in April 2000. Despite this broad-based expectation, the Nasdaq 100 (QQQ) still fell 78%.

• Argentina – The Argentine peso collapse in 2002 was the most telegraphed crisis in recent history. Again, although anticipated, the peso still plunged 73% versus the U.S. dollar, and the economy sunk by 16% in real terms.

• Finally, Bank of Japan and the carry trade – In late 2005 and early 2006, market participants were well aware of the Bank of Japan’s planned exit from its Zero Interest Rate Policy (ZIRP). They even knew that it was scheduled for March 2006. Despite this, the Nikkei (NASDAQ:EWJ) peaked at the end of March 2006 and then plunged 19% through June. Similarly, the exit from ZIRP triggered a severe correction in emerging market currencies – despite the fact that it was supposedly already built into expectations.

These precedents don’t give me much confidence that we are going to skate through the taper unscathed.

In addition, the problem today is magnified by the fact that financial markets are far shallower now than they were six years ago due to the onslaught of well-intentioned regulations. New rules have dramatically reduced the inventory financial institutions hold. What this means is that as the $5.5 trillion worth of liquidity injected by the Federal Reserve, the European Central Bank, the Bank of Japan, the Bank of England, and the People’s Bank of ChinaBank of China since 2008, is withdrawn, there is a much higher risk of an outsized market move coincident with the reversal of easy money.

Make no mistake, when events are anticipated potential damage can be reduced since economic agents are forewarned and can protect themselves. However, we must bolster that foresight with concrete policy action and contingency planning in order to minimize disturbances.

Therefore, given the unchartered waters we have entered, the Fed needs to think more strategically about its role. Specifically, it needs to incorporate a longer-term perspective into its actions by prioritizing a consistent and transparent policy. Similarly, the Fed should forego trying to fine tune labor market conditions in favor of achieving longer-term financial stability.

At first, markets may waiver and the pace of the economic expansion may stall. Yet, return to a more normal and clear monetary policy might finally encourage business investment, which has remained sidelined post crisis.

Similarly, emerging markets, tracked by the EEM ETF, have been hit hard since the taper with many questioning their future as an investment destination. I believe that the emerging markets miracle is alive and well. However, officials in emerging economies must also do their part by lining up reciprocal swap lines with friendly central banks, establishing contingent facilities with the International Monetary Fund (IMFIMF), and lastly re-embracing reform with the intent of getting the stamp of approval from the IMF and – most importantly – market participants.

If central bankers take these coordinated steps, they can better protect their respective economies from unforeseen consequences that accompany the taper. And, to be sure, there will be unforeseen consequences.

Simply believing that we will emerge from this experiment unscathed, because the ramifications from truly extraordinary policies over the last six years have somehow been magically priced into the market, is not an option. That, in my opinion, is not smart policy.

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